Individual retirement accounts (IRAs) are an attractive investment vehicle for many U.S. citizens and residents. However, they have limitations that an unsuspecting American living abroad can easily run afoul of. Here’s a quick rundown of what to look out for.
Not Enough Taxable Compensation
“For 2023, the total contributions you make each year to all of your traditional IRAs and Roth IRAs can’t be more than:
• $6,500 ($7,500 if you’re age 50 or older), or
• If less, your taxable compensation for the year”
Taxable compensation is the key term here. If you use the Foreign Earned Income Exclusion (FEIE), you could have made up to $120,000 in 2023 and your taxable compensation could be $0, if all of that income was excluded.
Pro tip: the standard deduction doesn’t matter when determining your taxable compensation, so you don’t necessarily have to actually pay any tax on the income for it to be eligible.
There are two ways to be able to contribute to an IRA even if you use the FEIE:
Earn income in the U.S. Amounts you’re paid for work performed while you were physically in the U.S. are not foreign earned income and therefore can’t be excluded under the FEIE – but you can contribute those amounts to your IRA, if you meet the other IRA requirements.
Make more than the FEIE limit. If your earned income is over $127,000 for 2024, the amount above that isn’t excluded income and can be contributed without any issues.
Important note: you can’t just arbitrarily choose to report part of your foreign earned income as if it was earned in the U.S. – you have to be able to explain how the amount was calculated.
Foreign Spouses
Since Roth IRAs are such an attractive investment vehicle, the IRS has restrictions to avoid people circumventing the income limitations. The one that we’re concerned with is a sharp restriction on taxpayers who file separately and live with their spouses.
“If your filing status is married filing separately and you lived with your spouse at any time during the year, and your modified AGI is ≥ $10,000, then you can contribute zero [dollars to a Roth IRA].”
This rule is designed to prevent couples with significantly different incomes from filing separately to allow the lower-earning spouse to circumvent the income limit, but it has the unintended side effect of essentially prohibiting Roth IRA contributions if you’re married to a nonresident alien.
There are two ways around this:
The “Backdoor Roth.” This widely known loophole – which also works for people who exceed the income limits – involves contributing to a traditional IRA first, then rolling over the funds into a Roth IRA. (Note that this is a frequent target of tax reform proposals and there’s a good chance it gets eliminated at some point).
Electing to treat your spouse as a resident alien for tax purposes. This can be a complicated decision, because it requires your spouse to file taxes just like you do – reporting their worldwide income, and using the foreign earned income exclusion and/or foreign tax credit to avoid double taxation. If your spouse doesn’t have a SSN, they’ll also need to apply for an Individual Taxpayer Identification Number (ITIN). You can read more about this option here.
Income Limitations
This usually isn’t an issue for most people who use the FEIE, but it does affect a lot of people who use the foreign tax credit. Here’s how your adjusted gross income affects your ability to make Roth IRA contributions:
For traditional IRAs, there are income limits for being able to take a deduction for contributions, but not on the ability to contribute. If you don’t qualify (or need) to take a deduction, you can make a nondeductible contribution, which will then reduce the tax you have to pay on distributions in the future. As mentioned earlier, you can also roll amounts over from a traditional IRA to a Roth IRA; if the amount in your traditional IRA was nondeductible, then at the time of rollover you only have to pay tax on the account’s earnings.